Of the 2 drug tests I have ever taken in my life (Pre_employment drug test for the job), they were never observed. I did have to empty my pockets of anything, leave my purse and any personal belongings with the lab person. I was not allowed to wash my hands or flush the toilet till I gave over my sample and sign a form stating it was completed. In your case, am surprised they would even allow the pad with you prior to the test, but, rather tell you after the test is done, can go back in the restroom and "freshen up" with a clean pad.
As for them observing, I don't see the big deal, since if they do this on a regular basis, most likely, they have seen it all, have no interest, and they could "possibly" not in effect watch you, but could hear, or see that you are in fact taking the test. There has been questions about observing, but the main reason is to avoid someone of trying to "beat" the system.
Most jobs only do a drug test for employment, but if in an accident, will do, or if they "suspect" drug use, will order the test. But some jobs, will always do "random" tests, since that is the reason for the 1 hour notice to get it done.
By failing to take this test, as one poster stated, you could have had 5 minutes of embarrassment, but, you could possibly be still employed, but refusing, you lost your job and guess what, you will be ineligible for UI benefits also.
good luck